The Chinese government repeatedly attempts to micro-manage the lives of its citizens. The effects of which continue to be unintended consequences both socially and economically. This week, we’ll discuss the citizens’ pool of money that the government continues to hold hostage and the mechanisms the Chinese government has employed thus far that have created a predictable ripple effect, visible to everyone but their own government. Somehow, they seem to be continually surprised by the unintended consequences of their own actions. We’ve watched Chinese investors’ money run from property to the stock market and now, to commodities. We’ll look at some of the massive scale of fairly predictable rookie trader outcomes that have been their unintended consequences.
The Chinese government has always maintained strict control over its citizens’ investments. Historically, the Chinese have been big savers due to an underdeveloped banking system. The rapid development of the Chinese economy over the last 25 years has dislocated an agrarian cash and barter system. The financial windfall that has come from the industrialization created a need for the banking system to modernize rapidly. This included educating the Chinese people as banking customers and on the principles of credit. At the time, housing, saving and venture capital were the few investment choices available. Thus, the banking and credit education dovetailed nicely with a booming property market…and we all know how that ends.
The economic collapse created a low in Chinese real estate from which, two enormous rallies occurred and we’re presently well into a third! Each of these troughs has been “managed” by the government’s lending policies as they attempt to find a stable pattern of growth. You’ll see on the historical chart that growth has been anything but stable and that is exactly our point: As the Chinese government marshals its citizens’ funds from one investment pool to the next, it places its citizens in the position of being a rookie trader over and over again. They’re pushed into real estate and expected to be real estate experts. They’re pushed into the stock market, as you’ll see next and finally, into commodities. Fortunately, we have a tool that helps us gauge the true value of a market by measuring the difference of opinion between the small speculators and the markets’ professionals.
As you can see, annual swings in excess of 20% aren’t uncommon. However, as a Chinese citizen, there were very few places they were allowed to invest. The Chinese government, by virtue of a captive market, could then control the supply and demand through the manipulation of their interest rates. Like any population, they’re no fools. As the bankers “educated” their new clients, their government began allowing them to invest in their own Chinese stock market. But first, you can see how quickly Chinese real estate is rebounding in response to recent monetary easing.
A recent study by the University of Missouri found that only 32% of Chinese people own any type of stocks, bonds or mutual funds. China is also the largest US debtor. They have to find ways to put all the US Treasuries they buy into circulation. This is led to a boom of uneducated individual investors. The unintended consequences of restricting citizens’ access to free markets were the stock and housing market bubbles. As the housing market led to the stock market collapse, the Chinese government began changing the rules to stem the tide of outflows. They eased stock buying margin requirements and relaxed rules on brokerage account openings. Increased margin buying combined with the influx of new market participants (sheep), helped push the Shanghai Composite Index (SHCOMP) to a new all-time high…..which still stands.
The Chinese government’s reactionary measures to stem the tide of their stock market crash included adding holding restrictions lasting days to months, depending on the trader’s holdings, in order to eliminate day traders and force institutional holdings to maintain their positions. They also instituted an outright ban on short selling. The restrictions placed on equity market traders combined with added economic stimulus created a pool of money looking for a home. Speculative easy money’s new home is the commodity markets. Once again, an unintended consequence, as the government intended for the stimulus to prop up the stock market.
Now that Chinese speculators have been burnt in housing and equities, thanks in no small part to the shepherding of their own government, it’s time for them to try their speculative hand in the commodity markets. This time, they’ve ended up right in our wheelhouse. Let’s begin.
There are three primary Chinese commodity exchanges. These are the Shanghai Futures Exchange (SFHE), the Zhengzhou Commodity Exchange (CZCE) and the Dalian Commodity Exchange DCE). The biggest difference between Chinese and American exchanges is the contract size. They tend to trade what we’d call, “mini” contracts. Once again, this is at the government’s discretion. The small contract size encourages participation, and participate they have! Morgan Stanley recently noted a two-week period where 18 of the top 25 commodities were traded on Chinese exchanges on a Dollar value weighted basis.
Small bets encourage small traders to enter the markets. Small traders are typically on the wrong side of the market. The Chinese commodity markets have seen a sharp bull run in 2016. Unfortunately, the physical demand to sustain this rally simply isn’t here. We’ve discussed at length the tremendous, and in some cases record, short positions we’re seeing the commodity producers execute via the weekly Commitments of Traders report. Given the influx of new traders (blood), it makes sense. Gold and silver miners, crude oil drillers and farmers alike have been hedging their anticipated forward production at rapid rates. Granted, there are other issues like negative interest rates and South American weather concerns facing some of the commodity markets but, importantly, the producers of the commodities that have seen the influx of buying don’t feel their products are worth the prices at which their markets are currently trading. See, “Global Economic Slack to End Commodity Rally.”
It is important to note that this is not the same type of action we saw during the 2010 commodity run up. That was based on commodity ownership and global economic demand for consumable commodities. This time around, it’s purely speculative. In fact, Bloomberg recently ran a story stating that a Chinese commodity account can be opened in less than 40 minutes, requiring only proper identification.
The bubble has subsided a bit. Recent volumes on the commodity exchanges have been brought back into line through additional fees at the exchange level but little else. China sincerely wants to take part in the global commodity futures trade. Listing comparable products is a key component of their pitch towards globalization. They’ve also taken key steps towards allowing direct foreign investment in their capital markets, including the commodity sector.
The kicker is being able to predict what the derivative (Chinese) market will do based off the action of its much larger and deeper, US counterpart. We view this as an opportunity to apply commodity trading tools we’ve developed on our efficient markets in a manner that should generate greater alpha as the same methodologies are applied to less efficient, Chinese commodity markets. This means the Commitments of Traders research we’ve been applying to the US markets should work equally well and perhaps better, in the less efficient Chinese markets. After all, it is based on finding value in the market as noted by the markets’ fundamental participants. Finally, we continue to see the rookie Chinese investors as aligning themselves with the small speculator category of the same report. Shepherded by their own government, we’ll watch them make each and every rookie trading mistake there is. Hopefully, we’ll be there waiting at each and every market turn.
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